Researchers looking into the mental mistakes made with money have come to the conclusion that humans are not hard-wired machines. In general, we lack the ability to properly measure risks and rewards and take correct action that's in our best interest. Good decision making is dependent upon understanding your own biases and tendencies; here are three big mental money mistakes and how to avoid them.
- Mob Mentality
Many individuals follow the crowd, and are uncomfortable otherwise. There is research to support the wisdom of crowds, but there is also research that shows "herding behavior" can be quite common - and damaging. Blindly following group decision making can lead to serious mistakes in your individual situation, as crowds can be spectacularly wrong and are not looking out for your best interests.
In the last bubble, many people followed the trend and bought homes they couldn't afford, which inevitably left them in the poor house. When you make a decision, think about the information upon which it was based. Do you really know the probability of success and failure? How much do you trust the information, and where did it come from? Is there any way to get information about the situation first hand, so you can make your own decisions?
Sure, this is more work, but you shouldn't avoid responsibility for your own actions. It's your life, and you'll be better off making your own decisions. (Home price appreciation is not assured. Can you withstand the volatility in this market? Find out in Why Housing Market Bubbles Pop.)
- Confirmation Bias
Individuals tend to seek confirming information for their beliefs, and ignore (or neglect to search for) conflicting evidence. In this instance, we could learn a thing or two from the scientific community. Scientists formulate hypotheses and attempt to prove them false. When investing, if your hypothesis is that a stock is going up, look for evidence to the contrary. That is the most valuable piece of information you will find.
It's common for people to believe they are right far more often than they actually are. To avoid this, find historical evidence of the situation, especially past averages. Positive thinking is just that: thinking. You'll need hard facts in order to make any significant progress, financially.
Given these mental money mistakes, it's easy to see how a small group of people could start buying real estate and push it above its value. When "quick" money like that is made on an investment, overconfidence is fed and more purchases are made. Subsequently, more people jump on this golden goose, not thinking objectively. Crowd mentality is formed, and prices begin to rise. Those people are usually more than happy with their investments - until the market crashes.
(Don't put the sale of your home at risk by committing one of the dirty deeds found in 12 Worst First-Time Homeseller Mistakes.)